Academic journal article National Institute Economic Review

Is Europe an Optimum Currency Area? Symmetric versus Asymmetric Shocks in the EC

Academic journal article National Institute Economic Review

Is Europe an Optimum Currency Area? Symmetric versus Asymmetric Shocks in the EC

Article excerpt

Introduction

Much of the debate on the desirability of a monetary union in Europe has focused on the question of whether Europe can be described as an optimum currency area (OCA). The European Commission in its report 'One money, one market' takes the view that this theoretical framework gives useful insights for the analysis of the economics of EMU and its potential costs and benefits, even though it is not decisive, but it has to be complemented by other approaches. Many studies have tried to provide an answer to the topical question of the optimality of introducing a single currency, adopting different research strategies. This note explains why a knowledge of the nature of the shocks is crucial to evaluating the potential costs of creating a monetary union, and applies a statistical technique known as principal components analysis to distinguish between common and country-specific shocks. After surveying the existing literature on OCAs, we present some new empirical results which confirm the relative importance of asymmetric shocks in the Community. A well-functioning monetary union could require some instruments for adjusting to shocks of this kind, for example fiscal transfers across the member countries.

Optimum currency areas

The adoption of a single currency will have both benefits and costs. The former will be mainly in the form of lower transaction costs and of the disappearance of currency risks. The latter will be due to the inability of national governments and central banks to pursue independent monetary policies to stabilise the economy. The extent to which the loss of this policy instrument will affect the adjustment to equilibrium will depend on the degree of flexibility of factor markets and the nature of the shocks hitting the economy: the more rigid factor markets and the more country-specific the shocks, the more important will be the loss of monetary autonomy. These issues are addressed by the theory of optimum currency areas (OCAs), whose implications are crucial to answering the question whether Europe should proceed to adopting a single currency. If factors of production are not sufficiently mobile, asymmetric shocks result in high costs of adjustment, in terms of higher unemployment and lower output, in the presence of fixed exchange rates.(1)

New Classical economists have long suggested that the transaction costs resulting from multiple currencies should be weighed against the benefits of each country being able to adopt its own optimal monetary policy. In their view, the problem of setting monetary policy in an optimal way is not dissimilar from that of choosing the optimal tax structure, as the process of money creation can be seen as being essentially a tax on private agents' money holdings. Consequently, if the macroeconomic environment is significantly different across countries, different tax structures and currencies are the optimal outcome.

The arguments for and against monetary integration are not as straightforward as those concerning economic integration more generally. As Paul Krugman (1989) says:

'The economics of international money, by contrast |to those of trade integration~, are not at all well understood; they hinge crucially not only on sophisticated and ambiguous issues like credibility and coordination, but on even deeper issues like transaction costs and bounded rationality'

In its study 'One Market, One Money' (1990), the European Commission relies heavily upon the theory of optimum currency areas to evaluate the economic impact of EMU. Much of the analysis is based on the framework developed by Robert Mundell, Ronald McKinnon and other economists in the 1960s, though it is stressed that other fields of economic research are relevant for the analysis of EMU. They include new contributions to the analysis of the following topics:

* the workings of markets in the presence of externalities, adjustment or information costs (see Baldwin, 1990);

* the choice of an optimal exchange-rate regime in a stochastic environment (see Argy, 1990, for a survey);

* macroeconomic games between the authorities and the private sector and policy coordination issues (see the seminal paper by Barro and Gordon, 1983, and the survey by Currie, Holtham and Hughes Hallett, 1989);

* the relative performance of alternative exchange-rate systems (see Baxter and Stockman, 1988);

* the economics of EMU (see Brociner and Levine, 1992). …

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